The Accounts Chamber of the Russian Federation issued a report on the audit of foreign economic activities practiced by Russia's largest diamond manufacturer, the Kristall Production Corporation based in Smolensk, according to Finmarket (www.finmarket.ru). Another aim of the auditing was to evaluate the efficacy and intended use of the federal property turned over to Kristall as an in-kind contribution within the frames of state support rendered to the company in the crisis period of 2008-2009.
In its report signed by auditor Alexei Kuzmitsky the controlling authority drew attention to a sharp increase in re-sales of rough diamonds by Kristall in 2010-2011, whose main business is diamond cutting, not re-export of rough. This phenomenon is not entirely in line with the essential measures "to strengthen the position of the Russian Federation on the global gems market," but it is largely due to the objective problems in the diamond industry and shortcomings in regulating the circulation of precious stones in the Russian Federation. However, Kristall refutes the findings of the Accounts Chamber to the effect that the company sold a lion's share of rough diamonds from the in-kind contribution.
Based on the auditing results, the Accounts Chamber submitted a representation to the Finance Ministry and an information letter to the government of the Russian Federation.
RE-SALE AS VIEWED BY ACCOUNTS CHAMBER
Until 2011, Kristall, like other Russian diamond manufacturers, could not export more than 15% of diamonds bought in each current year. This restriction was removed by the presidential decree issued on September 20, 2010 "On Approval of the Regulation on Import of Precious Metals, Precious Stones and Commodities Containing Precious Metals to Russia from Countries, which are not members of the Customs Union within the Eurasian Economic Community, and on their Export from Russia to these Countries."
The main conclusion of the Accounts Chamber is that after the 15-percent export quota for manufacturers was removed Kristall increased rough exports 4 times. If in 2010 Kristall sold 14.4% of the purchased rough earning $ 51.4 million, in 2011 the share of rough exports went up to $ 205.75 million (40% of the purchased goods value during the year), as it follows from the report of the Accounts Chamber.
It is noteworthy that more than 97% of rough diamonds were bought by Kristall in the domestic market. This includes more than half of all diamonds purchased by Kristall in 2008-2011 from Russian diamond monopoly ALROSA (ALRS). The long-term contract of Kristall with ALROSA expired at the end of 2012, and now the two sides are negotiating a new agreement.
RE-SALE AS VIEWED BY KRISTALL
Kristall’s management has always claimed that the company sells only that rough, which is not cost-effective for cutting purposes (IF note: The feasibility criteria are defined by the order of the Ministry of Finance.). According to Kristall’s CEO Maxim Shkadov, the share of rough exports in his company did not exceed 15% after the quota had been removed.
Kristall explains the sharp rise in its rough diamond sales in 2011 by the fact that it started to work with Yakutia’s diamond miner OAO Nizhne-Lenskoye. As Maxim Shkadov told Interfax, his company used to buy the entire product mix from Nizhne-Lenskoye for several years paying up to $ 100 million.
Nizhne-Lenskoye, which is annually producing about 2 million carats of diamonds mining them on the alluvial diamond fields in the north-west part of Yakutia, earned a revenue of RUB 4.44 billion in 2011. The company has high-quality rough at its disposal, but previously experts pointed to the opacity in its distribution policy and errors in corporate governance that led the company to a technical default in 2011. In late December 2012, ALROSA’s subsidiary Almazy Anabara acquired a 51% stake in Nizhne-Lenskoye from the Ministry for Property Management of Yakutia for RUB 3.7 billion.
Kristall is specialized in producing top-quality goods (Triple Excellent) and carefully selects diamonds for this standard, Maxim Shkadov explains. "The diamonds we need may account for just 20% of the entire box, while the rest gems are dispatched for sale and this is an absolutely market mechanism,” he said. “If you in theory take the entire mix of mined diamonds Kristall is specialized in processing only 10% of such rough by weight, but this share takes up 40-45% by value."
"All the customers of ALROSA and De Beers appear to be rough diamond dealers and are mainly engaged in reselling rough, re-sorting it and making up separate saleable parcels and also crediting their customers. Kristall is a full-scale member of the global market, acting along the same rules and earning from all transactions. The company is basically unable to cut all the purchased rough - it makes no economic sense," Maxim Shkadov said.
DISPARATE MARGIN
Margins earned from operations involving rough diamonds and polished diamonds are incomparable, as it follows from the report of the Accounts Chamber. This is the main reason for diamond manufacturers to resell rough diamonds.
Profits from selling Kristall’s underlying goods – polished diamonds – taking into account the high cost of diamond cutting were at their minimum level of 3-6%, according to the Accounts Chamber. Unlike polished diamonds, the added value in rough diamond exports ranged from 10% to 30% of the purchase price. The minimum level of trade mark-ups practiced by Kristall in selling its rough was 10% to 12%, while in case of a positive price movement in the global market the company established a 25% premium to purchase prices.
This kind of imbalance, which occurred in 2011, was caused by a sharp increase in diamond speculation by Indian companies, which, encouraged by the state, used virtually unsecured loans, Maxim Shkadov explains. "At that time, rough prices overtook polished prices making manufacturing unviable, and in order not to lose money, diamond manufacturers often preferred to sell these rough diamonds instead of cutting them," the head of Kristall said.
EXPORT CHANNEL
Kristall’s main export channel is Smolensk Diamonds NV, a Belgian company based in Antwerp. Kristall owns 99.89% of shares in Smolensk Diamonds NV, while an 0.11% stake in this subsidiary belongs to its managing director Raymond Cohen.
This Belgian “offshoot” of Kristall, as well as its subsidiaries in the UAE, Hong Kong and Israel account for 96.4% of rough diamonds and 32% of polished diamonds exported by Kristall. In 2011, these subsidiaries provided 48% of the parent’s annual revenue from sales (compared to 22% in 2009 and 27% in 2010).
If in 2008-2009 Smolensk Diamonds NV’s performance proved to be in the red (its total loss reached € 472,000), in 2010-2011 the company was in the black (driving its total income to € 748,300).
IN-KIND CONTRIBUTION
The increase in Smolensk Diamonds NV’s sales in 2011 was due to the fact that a significant amount of rough diamonds received as in-kind contribution from the Russian Federation to the charter capital of Kristall was sold to this subsidiary, the Accounts Chamber report says.
Kristall believes this conclusion is not true. According to Maxim Shkadov, the head of Kristall, the share of these diamonds was only 10% of the total sales of rough diamonds, and the manufacturer resold mainly those goods, which had been previously purchased in the market. "We buy rough at market prices and we sell at market prices as well. We bought 90% of later resold diamonds from a variety of sources on a common basis. And if we earned on the re-sale, what's wrong with that?" Maxim Shkadov said. He clarified that the money earned from these operations remained with the company, not transferred abroad.
In 2010, the state contributed rough and polished diamonds worth $ 130 million (563,000 carats of rough diamonds to the amount of $ 65 million and 40,000 carats of polished diamonds to the amount of $ 65 million) to the charter capital of Kristall to pay for its additional share issue.
The Accounts Chamber points out that there was no assessment of the market value of these gems. Actually, Gokhran calculated their value based on the price lists of the Russian Ministry of Finance at a markup of 16% for rough diamonds and 36-43% for polished diamonds.
Some part of rough received from the State Repository Kristall had to sell from the very start - 79% of these diamonds by weight and 34% by value were found uneconomical for manufacturing purposes.
Having additional amounts of gems received from Gokhran, Kristall increased the amount of borrowed funds by 64% to RUB 9.87 billion by the end of 2011. According to the report of the Accounts Chamber, Kristall used these raised funds not only for purchases of rough, but also for financial transactions, including the issuance of loans to various businesses and individuals (approximately for the amount of RUB 3 billion), in some cases without collaterals. The loans issued by Kristall have been returned, but the borrowers’ obligations were not secured, and there was a risk of damage to the financial operations of Kristall and its reduced liquidity. About 80% of the provided loans Kristall extended to one of its major suppliers of rough, Nizhne-Lenskoye as an advance against future supply of rough diamonds with deferred delivery exceeding 8 months.
These funds were used to make loans to the company’s employees under its own mortgage program to retain personnel, Maxim Shkadov said. In this case the security was their salary, from which deductions were made. The increase in borrowings was due to a 50-percent growth in rough diamond prices.
PRODUCTION
Kristall explained the need for rough diamonds from the State Repository saying that in the course of their processing it will be possible to provide maximum employment in the company, but in 2011 the company’s capacity utilization turned out to be 46%, which was even lower than in 2010 (52.3%). However, the Accounts Chamber notes that full capacity utilization is only possible if the company has mining assets.
Kristall did not stop even for a day, even during the deepest crisis in the history of the industry, and the lower capacity utilization rates suggest that the company had to maintain a balance between the number of staff (2,200) and machinery equipment, the head of the Smolensk diamond manufacturer said. "Last time Kristall’s production capacity was utilized to its maximum was in the Soviet era, when the state lent real support to the processing of natural resources," Maxim Shkadov reminds.
Of the amount of rough diamonds turned over to Kristall, the company used $ 38.5 million worth of gems (59% by value and 17% by volume) for manufacturing purposes, according to the report of the Accounts Chamber.
The transfer of diamonds to Kristall has led not only to higher re-sale operations: the Accounts Chamber noted that the company’s production went up by 24-34% in 2010-2011 compared with 2009. In 2011, the Kristall turned out 178,440 carats of polished diamonds worth $ 299.5 million, selling 191,900 carats for $ 366.7 million.
Meanwhile, the Chamber emphasized that Kristall did not adopt an investment program, or an innovation program, or medium-term development program until 2012. Kristall’s investments of RUB 344 million in 2008-2011 did not contribute to modernizing the production process and technology and did not result in reduced costs or increased productivity, according to the Accounts Chamber.
The program was approved in 2012, and this was the year when the most part of investments was made, Maxim Shkadov reminds and says that this was due to the fact that "cold hard cash" from the sale of the in-kind contribution emerged only in the second half of 2011.
As a result, there were no tangible shifts in solving the task to increase the share of the Russian Federation and that of the largest Russian diamond manufacturer, Kristall in the world market. Russia's share in the world production of polished diamonds was 8% in 2011. Kristall’s share in the world market by the end of 2011 reached 1.62% (1.94% in 2010), while its share in Russia was 40.7% (55% in 2010). There are objective reasons for that - significant growth of business run by Indian diamantaires whose goods have a wide range of prices with predominance of low-cost categories.
POLISHED SALES
In addition to rough diamonds, Kristall also received polished diamonds from Gokhran. In 2011, 97% of polished diamonds turned over from the State Repository as the contribution payment on the part of the Russian Federation, were sold. The revenue amounted to about RUB 2 billion, their selling price exceeding their transfer price by 5.2%.
Of the total polished sales by Kristall in 2008-2011, 74% ($ 904 million) falls on foreign markets. Some part of the diamonds earmarked for sale was given to Kristall’s subsidiaries - Smolensk Diamonds NV (16.7% of Kristall’s sales for four years), Hong-Kong-based Smolensk Diamonds Asia (8.1%), and Smolensk Diamonds USA (7.2%). The largest buyer of Kristall’s goods is Finstown Enterprises from the UAE, whose share in the company’s sales was 18.6% in 2008-2011. Besides Finstown Enterprises, Kristall’s customers include several Israeli, American and Belgian companies.
Gokhran was not only a major supplier of rough and polished diamonds to Kristall, but also a buyer of its goods. Gokhran purchased more than 92% of polished diamonds sold by Kristall in the domestic market to the amount of $ 292 million in 2008-2011. These purchases were also made as part of state support rendered to the company.
SHORTCOMINGS IN INDUSTRY REGULATION
The Accounts Chamber is not inclined to dramatize the fact and extent of rough diamond re-sale by Kristall - otherwise the controlling authority would have submitted a representation to the General Prosecutor's Office, Interior Ministry and Federal Security Service. In its concluding statement, the Accounts Chamber notes that "export of rough diamonds deemed economically impractical to be processed by the company gives an opportunity to get additional revenue and accelerate inventory turnover if resale markups are applied."
According to the document, Kristall finds it easier to sell rough diamonds to foreign customers through its Belgian subsidiary, as sales in the domestic market bring no profit for a non-mining company, which cannot offer attractive prices to end customers. In addition, the export of diamonds from the Russian Federation requires a large amount of documents and approvals from the state agencies. The process of obtaining an export documentation package takes from 3 to 6 months, which is conducive to overstocking. All the more so, that Kristall is re-sorting acquired lots to select cost-effective rough for further cutting and re-sorting is the prerogative of Gokhran inspectors.
Long terms needed to get rough when purchasing it in Russia in a rapidly changing market environment makes foreign buyers shy away from transactions in Russia, the Accounts Chamber stressed. It is much more convenient to trade through subsidiaries in Belgium, Israel, Hong Kong and the UAE, which can deliver goods to customers in guaranteed time, and in addition they are promoting such goods in the world diamond trade centers. In Antwerp, which accounts for up to 90% of all transactions concluded in this market, any deal takes up a maximum of 3 hours, including examination and inspection of a diamond assortment, price bargaining, making up a parcel of goods, payment and delivery.
"Sales of rough diamonds abroad happen only because there is no competitive market mechanism and its implementation in Russia due to excessive legal regulation ... while the presence of subsidiaries abroad gives the company an opportunity, being a participant in this market, to use the most appropriate methods for marketing and sales activities, pricing, as well as for being competitive in the global market," the Accounts Chamber sums up.
However, foreign operations performed by Kristall’s subsidiaries are not always protected from risks. One of the customers of Kristall’s subsidiary based in Belgium, which is Yossi Kuzi Diamond, an Israeli firm, was not able to pay for goods bought from the Russian manufacturer back in 2002 and still owes Kristall the sum of more than € 1.6 million. Smolensk Diamonds N.V. is trying to collect the debt in court and simultaneously is on the defensive from the claims of Antwerp’s tax authorities concerned by the lack of reserves in the financial reporting filed by Kristall’s subsidiary to offset the losses associated with this episode.
